CAPITAL BUDGETING

PAYBACK PERIOD AND NET PRESENT VALUE(NPV)

Reported by: Analyn “Anne” Grimaldo

PAYBACK PERIOD

is the amount of time required for the firm to recover its initial investment in a project are calculated from cash inflows.

Calculated as:

Payback Period=Cost of Project/Annual Cash Inflows

DECISION CRITERIA

• if the payback period is less than the maximum acceptable payback period accept the project.

• If the payback period is greater than the maximum acceptable payback period,reject the project.

Minacs Confidential 204/08/23

Table 10.1 Capital Expenditure

Project A Project B

Initial Investment P42,000 P45,000

Year Operating cash inflows

1 P 14,000 P28,000

2 14,000 12,000

3 14,000 10,000

4 14,000 10,000

5 14,000 10,000

Minacs Confidential 304/08/23

PAYBACK PERIOD

Payback Period

Project A

PBP = initial investment_

annual cash inflow

= 42,000

14,000

= 3 years

Minacs Confidential 404/08/23

PAYBACK PERIOD

Payback Period

Project B

PBP = initial investment_

annual cash inflow

= 45,000

14,000

= 3 years

Minacs Confidential 504/08/23

PROBLEM 1: PAYBACK PERIOD

You are financial analyst for Damon Electronics Company. The director of capital budgeting has asked you to analyzed two proposed capital investments,Project X and Y.

Each project has a cost of P10,000 and cost of capital for each project is 12 percent.

Minacs Confidential 604/08/23

Cont….PROBLEMS: PAYBACK PERIOD

EXPECTED NET CASH FLOWS

YEAR PROJECT X PROJECT Y

0 (10,000) (10,000)

1 6,500 3,500

2 3,000 3,500

3 3,000 3,500

4 1,000 3,500

Minacs Confidential 704/08/23

a. Calculate each projects payback period

b. Which project or projects should be accepted if they are independent?

c. Which project should be accepted if they are mutually exclusive?

d. Calculate each Projects the Net Present Value

Cont…SOLUTION: PAYBACK PERIOD

CUMULATIVE CASH FLOWS

YEAR PROJECT X PROJECT Y

0 (10,000) (10,000)

1 (3,500) (6,500)

2 (500) (3,000)

3 2,500 500

4 3,500 4,000

Minacs Confidential 804/08/23

Payback X=2 + 500 = 2.17 years 3000

Payback Y=2 + 3,000 =2.86 years 3,500

PAYBACK PERIOD

ADVANTAGES DISADVANTAGES

1. Payback period is quite simple to calculate

1. The major weakness is merely subjectively determined number.

2. It can be a measure how quickly the firm recovers its initial investment

2. Fails to take fully into account the time factor in the value of money.

3. It can be viewed as a measure of risk exposure.

3. Failure to recognize cash flows that occur after the payback period.

Minacs Confidential 904/08/23

NET PRESENT VALUE(NPV)

• This is done by discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment.

Calculated as:

NPV=Present Value of cash inflows-Initial Investment

04/08/2310

NET PRESENT VALUE(NPV)

Decision Criteria:

ACCEPT THE PROJECT REJECT THE PROJECT

If the NPV is greater than 0 If the NPV is less than 0

NET PRESENT VALUE

10,000 investment, 10 % discount rate

NET PRESENT VALUE

10,000 investment, 10 % discount rate

Microsoft Office PowerPoint 97-2003 Pres

NET PRESENT VALUE

Investment A Investment B Selection

Payback Method 2 years 3.8 years Quicker Payback: Investment A

Net Present Value 177 1,414 Higher Net Present value: Investment B

PROFITABILITY INDEX

A further possible refinement under the net present value method is to compute a profitability index.

Profitability index = Present value of the inflows

Present value of the outflows

PROFITABILITY INDEX

Investment A

PI = 10,177

10,000

= 1.0177

Investment B

PI = 11,414

10,000

= 1.1414

NPV and ECONOMIC VALUE ADDED (EVA)

• It is a PURE ECONOMIC PROFIT,a profit above and the beyond the normal competitive rate of return in a line of business.

• Calculated as:

• EVA=project cash flow-(cost of capital) x (invested capital)

Minacs Confidential 1804/08/23

Microsoft Office PowerPoint 97-2003 Pres

Thank you!

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